- In its new round of quantitative easing, the Fed’s operations are now open-ended, unlike in previous instances. What is more, in what could mark a turning point in its approach to monetary policy, it signaled that its loose stance might persist even once the recovery has started.
- This decision appears to reflect an underlying shift in emphasis in the Fed’s dual mandate: less concern about the threat of inflation and more concern about persistently anemic unemployment.
- If confirmed, it implies that the market rally is less likely to fizzle out quickly and that gold and risky assets will be supported beyond previous cycle highs. The USD will remain firmly on the backfoot.
So the Fed has done it. It announced its third round of quantitative easing (QE3), or more precisely, of credit easing. Earlier than many had anticipated at the start of the year (if at all), later than some doomsters expected, but in line with broad expectations as the Fed’s recent guidance had become ever clearer. Yet, this is not simply a reiteration of previous such efforts as the numbering might suggest, but is accompanied by a series of measures intended to ensure that the move is not subject to the feared diminishing returns to scale. What is more, these ingredients also have important market implications. The following are the key elements of the decision:
- Nature: QE3 will focus its firepower on mortgage-backed securities rather than US Treasuries. This makes some sense given that the transmission from policy and government rates to other market rates has been uneven at best.
- Size: The Fed will be buying MBS to the tune of $40 bn per month, which together with the continuation of ‘Operation Twist’ implies total monthly bond purchases amounting to $85 bn. This equates broadly to the size of the previous QE2 program in 2010.
- Duration: The real crux of the announcement is the fact that purchases will not have a preset end-date but will continue as long as necessary. In Mr Benanke’s parlance this is until the Fed sees “ongoing sustained improvement in the labor market”. The lack of specificity leaves the Fed with plenty of discretionary power while sending an important signal. The new approach represents a key break with the past, when closed-ended interventions led to temporary bouts of increased economic activity and market rallies, but fizzled out when investors began to discount the end of these operations. Importantly – though it didn’t require the explicit mention – the Fed stressed that it would not end its interventions “prematurely” and reserved the right to undertake additional asset purchases and deploy “other policy tools as appropriate” (subject to the price stability constraint).
- Rate Guidance: In addition, the Fed extended its guidance on interest rates, stating that they would remain “exceptionally low” until mid-2015, rather than the previous end-2014 date (but note that this extends beyond Mr Bernanke’s current term as Fed chairman).
A Turning Point?
The new approach behind what might appear to be fairly standard measures is perhaps best embodied in the statement “the committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens” (emphasis added). This may provide a first indication that the Fed is moving towards a policy advocated by Michael Woodford, Paul Krugman and others and summarized by Gavyn Davies: namely that it commit to preserve its exceptionally lax monetary stance until the estimated 15.6% nominal output loss incurred since the start of the crisis has been recuperated. Amongst other things, this implies that monetary policy would remain loose even if inflation were to rise above the 2% target.
Further evidence to this effect is that the decision was not triggered by a fear of deflation, the figleaf used to justify previous interventions. Indeed, while inflation expectations actually pointed upwards this time (see Chart), employment reports had remained persistently anaemic.
If this is indeed the Fed’s new thinking, it would represent a crucial turning point and could be instrumental in raising expectations of future nominal GDP, thus boosting investment and consumption expenditure today. Of course, the Fed would not embark on such a policy by stealth and reducing the nominal output gap by its full amount would be an outlandish proposition. This is all the more so, as the US economy had been on an unsustainable, credit–fueled growth path in the decade to 2007 and this trend rate should thus not even be aimed at.
Futile for the Economy perhaps, but not for Asset Markets
Indeed, it is questionable whether the Fed’s actions can affect the stated objective at all. A $2 trn balance sheet expansion has so far not been able to do it, though it has perhaps averted worse. Similarly, the size of QE3 purchases could easily approach another $1 trn if it is maintained until the mid-point of the Fed’s median forecast range for the unemployment rate (7%) is to be attained. But even at this scale, the objective may remain elusive. In fact, the Fed’s actions may do no more than partly defuse the deleterious impact of the looming ‘fiscal cliff’ – worth an estimated 4% of GDP. The ultimate net effect will depend on the degree to which Congress is able to smooth this cliff (i.e. reduce the size of the fiscal contraction) after the presidential election.
Of course, these operations are not without risks, as Chairman Bernanke admitted in his Jackson Hole speech. The economic impact may well be ambiguous and never become fully visible, but the potential costs of inactivity would be greater still. On the other hand, the implications for asset prices are significant.
The Fed’s balance sheet expansion is set to be the boldest globally as other central banks will likely lag the Fed in the aggressiveness of its monetary posture (we will believe the ECB’s commitment to “unlimited” security purchases when we see it). As such, the US dollar is likely to remain on the back foot, all the more so if the search for yield in an environment of low volatility drives capital outside the US. In DXY terms, this can mean a drop through the 2011 lows of 73.
- For other G10 currencies, there are three key implications:
- First, the reduction of tail risk by the ECB’s decision to engage in OMT amplifies the effect of the Fed’s balance sheet expansion for the pair. In the short term, this will thus support EURUSD. And while EUR positions have bounced back from record-large shorts they remain in negative territory, providing scope for further unwinding. But be warned that the ECB’s actions do not provide a solution but temporary relief only. What is more, the conditional nature of the purchases is ultimately time-inconsistent and any EUR strength is thus unlikely to be lasting.
- Second, USDJPY is likely to continue drifting lower, sporadic FX interventions and additional BoJ asset purchases notwithstanding. Typically, a “risk on” environment pushes the pair higher, but in this case the interest rate effect of lower US rates is set to dominate. USDJPY will thus likely retest the 76 lows.
- Third, AUD is no longer trading simply on global risk perceptions. Instead, risk perceptions have begun to fragment as decisive policy action has made contagion appear more containable regionally. While US QE will provide some support for AUDUSD, ultimately prospects will be more influenced by developments in China (continuing to track 12m CNY forwards).
- In rate space, previous rounds of QE have driven 10y UST yields up by around 100bps, on the back of expectations of improving activity and rising inflation. However, the upside appears more modest this time, all the more so as Operation Twist is set to continue. The friendlier environment is also likely to be supportive for Bunds. But here too, with 10yr Bund yields already up from 1.20 to 1.60, it may not be the best time to enter positions.
- Risky assets in general are set to benefit from super-easy money across the world. This will support alternative investments like art, cars and wine. Gold is set to benefit as well as fears of inflation (albeit unfounded) ratchet up. High yield credit has further to gain, especially outside the non-financial, non-periphery sphere in Europe. The attractiveness of EM economies remains in place but will be countered by attempts to offset the impact of the QE-driven capital influx. Latin American economies in particular are set to intervene to keep their currencies from appreciating. In this respect, the EEMEA region has the most to gain as it has been the biggest casualty to date of the Eurozone’s travails.
- Last but not least, the equity space is likely to record further gains. During previous episodes of US QE, the S&P has rallied 50-60bps. In the current episode, the policy move targets both mortgage bonds and Treasuries (as ‘Twist’ continues) and is open-ended, providing for a potentially even larger impact (all else equal). Attaining the 1565 high of 2007 is thus not out of reach.